There’s something about crypto that attracts interest, like the new kid in town. Maybe it’s because it reminds us of the Wild West, conjuring up images of bandits and lawlessness. Unfortunately, that’s not a stretch, given the stream of illicit activity connected to crypto. The U.S. Department of Justice recently recovered US$3.6 billion in bitcoin stolen in 2016 from Bitfinex. Good thing there was a sheriff in town.
But even in the gritty throes of history, we know that most of the new kids in town were law-abiding pioneers, some with an admirable rebellious streak. They were driven by reinvention, expansion and to challenge the establishment.
The crypto frontier has these characteristics. Expansion is clear. The crypto market has exploded from just US$16 billion five years ago to some US$2 trillion today. There’s reinvention too. The crypto ecosystem is challenging the traditional financial system, which, for all its strengths, is also often inefficient, expensive and exclusive. Some of the pioneers have Canadian roots: Vitalik Buterin, co-founder of Ethereum, just made the Maclean’s power list.
We need to sort out what differentiates a bandit from a law-abiding pioneer to achieve the benefits of financial innovation for households and businesses, and avoid the build up of systemic risk. Clear and proportionate legal and regulatory frameworks for the emerging crypto ecosystem is the right way to do this. We’ve learned the hard way that unchecked risks in the financial system can have real consequences for taxpayers and those that can afford it the least.
What are some of the issues? Let’s start with an unbacked crypto asset such as bitcoin. Bitcoin lacks a credible mechanism to stabilize its value, so its price is highly volatile. That’s why bitcoin is a speculative asset rather than money, and why individual holdings are subject to capital gains taxes in many jurisdictions.
About 95 per cent of the crypto market is unbacked. Much more needs to be done with respect to investor protection and market integrity, particularly given that exposure to these assets is widening to retail investors via crypto exchanges and financial products such as crypto-based ETFs. While authorities around the world have begun to respond, regulatory frameworks are still very much a work in progress.
To its credit, the Canadian Securities Administrators was one of the first to establish registration requirements for crypto trading platforms. The CSA has also set expectations with regards to client protection. It’s a start. What’s trailing are the regulatory, supervisory and enforcement capacities.
Stablecoins try to address the issue of instability of unbacked crypto assets, but they raise other issues, including the quality and transparency of backing arrangements. This new kid promises to make a difference lowering the cost of domestic and international payments. That said, any benefits will only be realized if stablecoins are safe. Remember last year, when a U.S. regulator fined Tether (a prominent stablecoin issuer) for making misleading statements and omissions of material facts related to their backing arrangements?
Here’s another place where suitable regulation could help. The Bank of England’s Financial Policy Committee, of which I am a member, has set out intuitive expectations for systemic stablecoins. Canada doesn’t need to start from scratch. It can look to the Bank of England’s efforts and other international work in this area as it considers its own regulatory response.
The opportunities and risks extend beyond the crypto assets themselves. Lending, insurance, and other financial services are rapidly changing. It’s increasingly enabled by DeFi, or decentralized finance, running predominantly on the Ethereum blockchain. I see through my work with the Creative Destruction Lab at the Rotman School of Management the energy that is going into DeFi’s development; the total value locked in DeFi is already around US$200 billion and growing fast.
Developers and investors think that DeFi has several advantages over centralized ecosystems. Decentralization reduces the reliance on intermediaries and their inefficient infrastructure. Smart contracts enable automated execution and creation of new financial instruments and digital assets. DeFi protocols are open source, so the code is visible and easy to audit. Every transaction is visible on the blockchain.
Even so, DeFi arrangements raise familiar issues that will require regulation. The most immediate issues relate to fraud, misappropriation, conflicts of interest and cyber attacks. In some cases, despite claims to the contrary, operations and activities within DeFi are governed or administered by a small group of developers and investors. There’s also a risk of money laundering and terrorist financing. The Financial Transactions and Reports Centre of Canada and its international counterparts are working to advance a regulatory framework. They’ll need support to make the necessary investments in person power, expertise, and technology to support supervision and enforcement.
What about financial stability? The crypto ecosystem is growing at light speed and the emergence of leveraged players is something to watch. A sharp fall in the value of crypto assets could trigger margin calls, forcing leveraged investors to liquidate positions. This could snowball into other asset classes, especially if interconnectedness with the traditional financial system keeps growing. Déjà vu?
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The future of this new frontier depends critically on the regulatory response to the new kids in town, and how fast the traditional financial system modernizes. The incumbents are working hard to increase the quality of their services, reduce costs and increase access to customers. This is a positive outcome because it should increase competition in financial services, an industry that tends to be dominated by a relatively small group of larger players.
We should aim to safely pursue the promising use cases in crypto. Yet, this space is still advancing in a largely unregulated way, with few guardrails with respect to financial stability, investor protection and market integrity. That means it’s not entirely safe, and making it so raises complex issues.
But the traditional banking system raises complex issues, and we built a regulatory framework that is widely recognized as having spared Canadians from the worst of the global financial crisis in 2008 and 2009. Canada needs to be as ambitious in creating modern legal, policy and regulatory frameworks for the crypto ecosystem. If done well, we just might realize the promise of reinvention and expansion for those who rely on efficient and trustworthy financial services.
Carolyn Wilkins is a member of the Bank of England’s Financial Stability Board and senior research scholar at Princeton University’s Griswold Centre for Economic Policy. She was senior deputy governor at the Bank of Canada from May 2014 to December 2020.